Over the Counter Markets

Over the counter markets are a particular type of financial market. Generally, financial markets are centralized. This means that there is one central body that is a counterparty to all the trades being made.

For instance, if A wants to trade with B, the transaction does not happen directly. Instead, A trades with the centralized exchange, and B also trades with the centralized exchange. As a result, the exchange becomes the counterparty to all the trades.

However, over the counter markets function differently. Their functioning has been explained in detail in this article.

What is an Over the Counter Market?

An over the counter market is a decentralized system in which the buyer and the seller meet directly to conduct trades. The search for a counterparty may be facilitated by a broker. However, there is no centralized exchange that acts as a counterparty to all the trades.

Hence, if two people agree to buy and sell securities but decide to do so without involving any exchange, it is said to be a transaction happening on the over the counter market. The over the counter market is not a physical market. Instead, all trades happen electronically.

Many large companies prefer to transact in the over the counter market because of the secrecy that it provides. Since there is no central exchange, there is no need to share any data with any third party.

The details of the transaction and even the existence of the transaction can remain completely confidential if the participants want it to be that way.

Also, since there is no exchange involved, which is taking a risk with its own capital, the transaction costs in the over the counter market are also quite low as compared to exchanges.

Importance of Over the Counter Markets

Retail participants are not generally aware of the existence of over the counter markets. This is because whenever retail investors trade, they route their investments through exchanges. However, this is not the case with institutional investors.

Institutional investors extensively use over the counter markets. This is the reason why more than 40% of all the trades which happen in the world are routed via over the counter markets.

The type of securities traded on the over the counter market is different from the ones traded on the stock exchange. Transactions on the stock exchange are limited to blue-chip equity and highly rated debt. This is where the over the counter market is different.

Penny stocks, junk bonds, derivatives, and such other risky securities are extensively traded on the over the counter market. It would, therefore, be fair to say that over the counter markets are invisible to the retail investor but are actually vital for the smooth functioning of global financial markets.

Limitations of Over the Counter Markets

Over the counter markets pose some serious transaction risks. It is important that the participants indulging in over the counter trading have a clear understanding of the underlying risks which are involved. Some of these risks have been mentioned below:

1. Lack of Information: Over the counter markets provide secrecy. This can be viewed as a positive point for the parties involved. However, this is also a negative point for the other market participants at large. This is because there is very little information provided about the trading, which happens on the over the counter markets.

   As a result, price discovery is difficult. It is possible that different parties pay very different prices for the same security while trading on the over the counter market. Therefore, it would not be advisable to transact on the over the counter market until the buyer and seller are sure about the price of the underlying security.

   Also, since transactions are not reported, risk mitigation mechanisms like price circuits, etc. do not apply to these transactions.

2. Credit Risk: There is an inherent default risk that is present while trading on the over the counter market. The over the counter market does not guarantee the follow-through of the contracts. This means that parties may enter into swap agreements with one another.

   However, when the trigger event actually occurs, one of the parties may simply go bankrupt, and this makes the entire contract redundant. This does not usually happen. However, it does happen some times, for instance, the Great Recession of 2008. The problem is that if one party goes bankrupt, their contracts are dishonored, and the contagion quickly spreads to other parties as well. Credit risk has the potential to trigger a systemic crisis.

3. Liquidity Issues: Lastly, as mentioned, retail investors do not trade in the over the counter market. Also, financial institutions tend to limit their exposure to these markets. This means that it is quite difficult to find a counterparty in these markets on some occasions. Hence, it would be fair to say that the markets pose liquidity risk. As a result, if the same security is traded on the exchange as well as on the over the counter market, the price on the over the counter market should be lower to reflect the liquidity risk which the investor will have to face.

Hence, it would be fair to say that the over the counter market has several shortcomings. However, it would also be fair to say that despite these shortcomings, the over the counter market is widely used across the world.